Politics

IMF Deputy Stanley Fischer on the IMF and the East Asian
Crisis

Stanley Fischer 1

Los Angeles, March 20, 1998

The Asian crisis and the Administrations request
to Congress for IMF funding have focused unprecedented attention on the
Fund. The ensuing debate should be a healthy part of the process by which
the institution is held accountable to its member countries and governments.
But the spotlight on the Fund has also revealed a number of critical misconceptions,
relating both to its role in the international monetary system and to its
recent activities in Asia.

On the role of the Fund: it is often stated that the Fund was established
to manage the system of fixed exchange rates set up at the end of World
War II, and that since the breakdown of that system in 1973, it has been
searching for a rationale. The Fund has of course evolved and adapted since
it began operating in 1946. Nonetheless, its current activities are closely
consistent with its initial purposes -- testimony to the remarkable foresight
of the founders of the international economic system set up after World
War II, a system which has helped produce more growth and more prosperity
for more people than in any previous fifty year period.

In Asia it has been charged, among others by Martin Feldstein in the
March/April issue of Foreign Affairs that the Fund is applying traditional
austerity remedies; that it is intervening excessively in borrowers
economies, thereby making countries increasingly reluctant to request financial
assistance from the Fund; and that its activities bail out unwise lenders
and lay the seeds for future excesses of private sector lending -- the
moral hazard argument. I will argue that the Funds macroeconomic
advice in Asia is appropriate to the circumstances of individual countries;
that the structural changes in these economies supported by IMF programs
are necessary for the sustainable return of growth; that IMF lending should
be conditional on changes in policy and not too easily available; and that
while the existence of any insurance -- and the IMFs provision of
backstop financing does provide insurance to its members and the markets
-- produces moral hazard, most lenders to the Asian countries in crisis
have taken large losses.

It will always be true, though, that the international community needs
to find better ways of preventing crises and of dealing with the crises
that will inevitably occur, and I will conclude by briefly discussing changes
in the architecture of the international system now on the agenda.

The Purposes and Role of the IMF

The goal of the representatives of the 44 countries who met in Bretton
Woods, New Hampshire in 1944 was to rebuild the international economic
system, whose collapse had contributed to the Great Depression and the
outbreak of war. To this end they proposed setting up the International
Monetary Fund, the World Bank, and what much later became the World Trade
Organization.

The primary purposes of the Fund are set out in Article I of the charter,
which has remained essentially unchanged over the past fifty years. They
include:

"To promote international monetary cooperation through a permanent
institution which provides the machinery for consultation and collaboration
on international monetary problems";

"To facilitate the expansion and balanced growth of international
trade, and to contribute thereby to the promotion and maintenance of high
levels of employment and real income ...";

"To assist in the establishment of a multilateral system of payments
in respect of current transactions ... and in the elimination of foreign
exchange restrictions which hamper the growth of world trade"; and

"To give confidence to members by making the general resources
of the Fund temporarily available to them under adequate safeguards, thus
providing them with opportunity to correct maladjustments in their balance
of payments without resorting to measures destructive of national or international
prosperity."

The world economy has prospered mightily and changed dramatically since
1944, but the approach laid out at Bretton Woods has stood the test of
time. The IMF too has changed, but its original purposes remain valid on
the verge of the twenty first century.

International economic cooperation

The Fund, with its 182 member countries, is the premier forum for international
economic cooperation and consultation. Issues relating to the organization
and functioning of the international system are generally discussed and
where decisions are needed, decided on in the Fund -- by the Executive
Board, 2 and by the Finance Ministers and Central Bank governors
who constitute the Board of Governors of the Fund. Often the initiative
may come from elsewhere, for example the G-7, or a member government, but
it is the Fund that "provides the machinery for consultation and collaboration
on international monetary problems" that is used to examine and make
these suggestions operational. The Funds highly professional staff,
including 1000 economists, 450 of them with Ph.Ds, prepares the analysis
that forms the basis for the discussion.

Almost every major international economic problem of recent years has
been discussed and usually acted on (often together with other institutions,
especially our Bretton Woods non-identical twin, the World Bank) by the
IMF: the Mexican and Asian crises; technical and financial assistance to
the economies in transition, including Russia; the debt problems of the
poorest countries (in close cooperation with the World Bank); the attempt
to improve international banking standards; economic assistance to Bosnia-Herzegovina;
the ongoing effort, initiated following the Mexican crisis, to improve
the quality and public provision of data, which has led to the Funds
Special and General Data Dissemination Standards; the unfortunately long-running
problems of the Japanese economy this decade; the activities of hedge funds
and their role in the Asian crisis; and the list goes on and will go on.
3

Much of what the Fund does consists of surveillance, reporting
by the staff to the Executive Board and thus to member governments on developments
and problems in the international economy and in individual economies.
The staffs surveillance of the international economy is published,
after discussion by the Board, in the semi-annual World Economic Report
and in the annual International Capital Markets report. In addition,
the staff reports regularly to the Board on world economic and market developments.
Drawing on its continuous surveillance of the world economy, the Fund staff
provides briefings on the international economy for meetings of the G-7
and other Gs and organizations, including APEC.

Approximately once a year, the Fund staff prepares an Article IV
report for each country, an in-depth analysis of the countrys
economic policies and performance. In its discussion of the paper, the
Board conveys its views -- encouraging or critical -- to the policymakers
of the country. Through this process, policymakers seek to encourage their
colleagues in other countries to improve policies. In addition, the staff
reports regularly to the Board on countries facing particular economic
difficulties or whose programs with the Fund may be off track.

Article IV reports are not published: most member governments say they
would not be willing to discuss their economic problems frankly with the
Fund if the reports were to be published. However, last year the Board
agreed to allow countries that want to do so, to publish the Chairmans
summing-up of the Board discussion. So far 60 PINs (Press Information Notices)
containing the summing-up and other information on the economy, about half
the number of Article IVs discussed during the period, have been published,
and are available on the Funds website. In addition, at the end of
its Article IV mission to each country, the Fund staff mission presents
to the government a concluding statement, summarizing its views. The concluding
statement generally foreshadows the conclusions of the Article IV report.
Countries may, if they wish, publish these concluding statements, and an
increasing number are doing so. Thus, gradually, the Funds membership
is moving to make public the conclusions of the Article IV consultation,
a trend that is welcomed by Fund management.

In recent years, especially in the wake of the Mexican crisis, the IMF
has strengthened and broadened its surveillance, paying particular attention
to, among other factors, the quality and timeliness of the data it receives
from member countries, the strength of their domestic financial systems,
and the sustainability of private capital inflows. By providing warnings
of impending problems, Fund surveillance should help prevent crises. When
it does so, when a crisis is averted, surveillance has succeeded and is
unlikely to be noticed -- and there are many cases in which Fund warnings
were given and action taken that averted a crisis. But surveillance may
fail, either because warnings are given and not heeded, or because the
problem was not anticipated.

In the Asian crisis, the Fund warned Thailand of an impending crisis
but action was not taken. Fund staff also warned about financial sector
weaknesses in several of the countries subsequently badly hit in the crisis.
But we failed to foresee the virulence of the contagion effects produced
by the widening crisis.

In drawing the lessons of this crisis, the Fund will have to seek both
to make warnings more effective and to improve the quality of Fund economic
forecasts, particularly of crises. Many have suggested that crises could
be prevented, or at least mitigated, if the Fund went public with its fears.
Two factors make this difficult. First, the Funds access to information
and its ability to act as a confidential advisor to governments would be
lost if it made that information public; and absent such information, there
is no good reason to think this is particularly a task for the public sector.
Second, the Fund could by going public with its concerns create a crisis
that otherwise would not have happened -- a responsibility that should
not lightly be assumed. As to forecasts of potential crises, there should
be no illusion that forecasting of this type will ever be perfect. Some
impending crises will be missed. For this reason, and because in any case
not all warnings are heeded, we shall have to continue to improve our capacity
to deal with crises even as we strive to improve surveillance to prevent
crises.

Promoting international trade

The Fund promotes international trade directly, by encouraging trade
liberalization, both through surveillance and in its lending programs with
member countries. It has always done so, and the purposes of the Fund require
it to continue to do so. It is therefore a surprise that our Asian programs
are criticized for including conditionality on trade liberalization measures.
Although trade liberalization was at one time controversial, and import-substituting
industrialization a popular prescription, the weight of experience, as
well as more formal econometric evidence, have conclusively established
the benefits of trade liberalization and integration into the world economy.

Even more important, the Fund promotes international trade indirectly,
by encouraging countries to liberalize foreign exchange controls on trade
in goods and services ("the establishment of a system of multilateral
payments in respect of current transactions"). These controls were
pervasive at the end of World War II, but by now 142 member countries have
accepted Article VIII status with the Fund, which certifies that they allow
full convertibility of their currency for current account transactions.
Remarkably, most of the transition economies moved to Article VIII status
within a few years, a contrast with many of todays advanced economies
which took well over a decade to get rid of these restrictions after the
end of World War II.

Currency fluctuations

The pegged exchange rate system set up at the end of World War II lasted
until 1973. In principle the IMF was assigned a major role in approving
exchange rate changes, but in practice major countries tended to devalue
first and seek approval immediately after. The fixed exchange rate system
was a means of promoting exchange rate stability, not a goal. Once it lost
its viability -- a result of the incompatibility of fixed exchange rates,
capital mobility, and policies focused on domestic objectives -- there
was no choice but to move to a more flexible system.

Exchange rates among the major countries, particularly between Japan
and the United States, have fluctuated more than was expected by proponents
of floating exchange rates, but no acceptable alternative is available
for countries that -- unlike future members of the European Monetary Union
-- are not willing to subordinate economic policy to the goal of stabilizing
the exchange rate. Fluctuations such as those in the yen-dollar rate between
81 in the spring of 1995 and 133 late last year are so large that the search
for a better way to promote exchange stability is bound to return to the
agenda. Smaller countries, more dependent on the international economy
than the United States, Europe, and Japan, do not have the luxury of ignoring
the behavior of the exchange rate, and have tended either to choose some
form of exchange rate peg or at least to adjust macroeconomic policies
when the exchange rate threatens to move out of line. The peg of most ASEAN
exchange rates to theappreciating dollar contributed to the Asian currency
crisis.

The concern over competitive devaluations reflected in the Funds
charter, and the system-wide implications of changes in exchange rates,
still motivate Fund policy recommendations. A major Fund concern in the
Asian crisis has been the fear that Asian currencies would become so undervalued
and current account surpluses so large as to damage the economies of other
countries, developing countries included. This is one reason the Fund has
stressed the need first to stabilize and then to strengthen exchange rates
in the Asian countries now in crisis -- and for this purpose, not to cut
interest rates until the currency stabilizes and begins to appreciate.

Fund lending

Despite its other activities -- surveillance, information provision,
and technical assistance -- the IMF is best known for its lending. The
Fund operates much like a credit union, with countries placing deposits
in the Fund, which are then available to loan to members who need to borrow
and who meet the necessary conditions. Members quotas in the
Fund determine both the amount they have to subscribe, and their voting
shares. The size of a members quota reflects, but typically with
a lag, the size of its economy and its role in the world economy. 4

Total quotas now amount to a bit under $200 billion. Countries have
to pay in 25 percent of their quota (the so-called reserve tranche) in
any of the five major currencies in the SDR; the remainder can be paid
in the countrys own currency. This means that not all the quotas
can be used for lending. Countries can have virtually automatic access
to their reserve tranche, and the U.S. has drawn on its reserve tranche
more than twenty times, most recently in defense of the dollar in 1978.

In September 1997 the members agreed to increase quotas by 45 percent,
about $90 billion, with the United States share of the increase amounting
to nearly $14.5 billion. The Congress has before it at present both the
Administrations request for the quota increase, and a request for
$3.5 billion for the United States contribution to the New Arrangements
to Borrow (NAB). The NAB will allow the IMF to borrow from a group of 25
participants with strong economies in the event of a risk to the international
monetary system. 5 It would thus provide backup financing
that could be available if the Fund runs short of regular quota-based resources.
The NAB doubled the resources available to the Fund under the General Arrangements
to Borrow established in the 1960s.

When a member in crisis approaches the Fund for a loan, the Fund seeks
to negotiate an economic program to restore macroeconomic stability and
lay the conditions for sustainable and equitable growth, paying careful
regard to the social costs of adjustment. The decision whether to support
the country will be taken by the Executive Board, based largelyon the strength
of the reform program the country is willing to undertake. The loan is
typically tranched, paid out in installments, each conditional on
the countrys meeting the conditions to which it has agreed. These
procedures, especially conditionality, constitute the adequate safeguards
required by the Articles of Agreement.

The policies agreed in a Fund-supported program typically include fiscal
and monetary policies, designed to restore viability to the balance of
payments, help restore growth, and reduce inflation. Where appropriate,
they also include structural policies designed to remedy the problems that
led to the need to borrow from the Fund. When a countrys problem
is purely balance of payments related, and can be expected to be reversed
in a short time, the Fund loan will typically cover policies for a year,
with repayment starting after three years and concluding within five years.
When the countrys economic problems are more deep-seated and will
take longer to deal with, the arrangement will last longer, covering policies
for up to three or four years. In these cases, the program will contain,
along with monetary and fiscal policy changes, more structural measures,
such as reform of the financial system, the pension system, labor markets,
agriculture, and the energy sector. Such extended arrangements typically
include reforms that will be financed during the period of the program
by World Bank loans. Such is also the case with the financial sector and
other structural reforms in Asian countries.

Despite the common usage, "IMF program", the Fund itself is
careful to speak of a "Fund-supported program". Ideally the program
should be that of the country, and one that its government is committed
to carry out. Of course, in the loan negotiations, the Fund will usually
ask the government to do more than it initially wanted. But because a program
is unlikely to succeed unless those who have agreed to it intend to carry
it out, a key element in the evaluation of any agreement is the degree
of the governments commitment to the economic program which it has
signed -- a conclusion which is reinforced by the recent Asian experience,
in which the Korean and Thai financial markets both turned around when
new governments, strongly committed to carrying out the programs, came
into office. The governments commitment may be difficult to judge,
especially if it is divided, and if, as happens not rarely, the program
is being used by those who favor reform as a vehicle to implement changes
that some of their colleagues oppose. Although a Fund-supported program
is often seen in the press as the international communitys way of
imposing changes on a countrys economy, it is more often the international
communitys way of supporting a government or a group within the government
that wants to bring about desirable economic reforms conducive to long-term
growth.

But why then are programs so often unpopular? The main reason is that
the Fund is typically called in only in a crisis, generally a result of
the governments having been unwilling to take action earlier. If
the medicine to cure the crisis had been tasty, the country would have
taken it long ago. Rather the medicine will usually be unpleasant, in essence
requiring the country to live within its means or undertake changes with
short-term political costs. Probably the government knew what had to be
done, but rather than take the reponsibility, finds it convenient to blame
the Fund when it has to act. Similarly, when structural changes have to
be made, the losses are often immediate and the gains some way off. Despite
all this, there are countries where the Fund is popular, among them transition
economies that have seen hyperinflation defeated and growth begin during
Fund-supported programs.

The secrecy that until recently has often attended Fund-supported programs
may well have contributed to their unpopularity. A public that does not
know what is being done, nor why, is less likely to support measures that
are difficult in the short-run but that promise longer-run benefits. Governments
have often been reluctant to publish their agreements with the Fund, disliking
to give the impression that their policies were in any way affected by
outsiders. Recently, in the Korean, Thai and Indonesian programs, the governments
Letter of Intent, its letter to the management of the Fund describing its
program, has been published --another change welcomed by the management
of the Fund.

Evolution of the world economy and the IMF

While the purposes of the IMF have not changed, it has over the years
been called upon to advise and assist an ever wider array of countries
facing an ever greater diversity of problems and circumstances -- not only
industrial economies with temporary balance of payments problems, but also
low-income countries with protracted balance of payments difficulties;
transition countries struggling to establish the institutional infrastructure
of full-fledged market economies; and emerging market countries seeking
to secure the private capital inflows needed to maintain high rates of
economic and human development.

Of course, the IMF has maintained its primary focus on sound money,
prudent fiscal policies, and open markets as preconditions for macroeconomic
stability and growth. But increasingly, the scope of its policy concerns
has broadened to include other elements that also contribute to economic
stability and growth. Thus, to different degrees in different countries,
the IMF is also pressing, generally together with the World Bank, for sound
domestic financial systems; for improvements in the quality of public expenditure,
so that spending on primary health and education is not squeezed out by
costly military build-ups and large infrastructure projects that benefit
the few at the expense of many; for increased transparency and accountability
in government and corporate affairs to avoid costly policy mistakes and
the waste of national resources; for adequate and affordable social safety
nets to cushion the impact of economic adjustment and reform on the most
vulnerable members of society; and in some countries for deregulation and
demonopolization to create a more level playing field for private sector
activity.

This broadening of the scope of IMF policy concerns has met with mixed
reactions. Some applaud the Fund for tackling the structural problems and
governance issues that, in many countries, stand in the way of macroeconomic
stability and sustained growth. But others roundly criticize the IMF, either
for intruding too far in what they see as the domesticaffairs of sovereign
nations, or for failing to go far enough.

Finally, the diversity of its membership and the problems they face
has led the IMF to establish a wider array of facilities and policies through
which the Fund can provide financial support to its members. In addition
to the traditional stand-by arrangement that usually lasts twelve to eighteen
months and is designed to help finance temporary or cyclical balance of
payments deficits, the Extended Fund Facility (EFF) supports three to four-year
programs aimed at overcoming more deep-seated macroeconomic and structural
problems. The Enhanced Structural Adjustment Facility (ESAF) also finances
longer-term programs, but at a concessional interest rate for low-income
countries. At other times in the IMFs history, new facilities have
been established to address particular problems. The most recent of these
is the Supplemental Reserve Facility (SRF), which was created in December
1997 to assist emerging market economies facing crises of market confidence,
while providing strong incentives for them to return to market financing
as soon as possible: it allows the Fund to make large short-term loans
at higher rates than it normally charges. The first borrower under the
SRF was Korea.

What is the net effect of all these changes? Certainly, the IMF has
not been completely transformed. One important feature that remains the
same is the emphasis on sound policies at national level and effective
monetary cooperation at the international level. The corollary of this
is that the IMF is not just a source of financing or a mechanism for crisis
management, as is commonly believed, but mostly, in its daily business,
a cooperative institution for multilateral surveillance. It must also be
acknowledged, however, that from its relatively simple origins, the IMF
has evolved into a complex institution with complex tasks to fulfill. So
even if the IMF continues to look at all its member countries through the
same prism -- the requirements for economic stability and growth -- it
has to deal in a differentiated way with the full spectrum of problems
and possibilities in 182 distinctive member countries.

The IMF and the Crisis in Asia

Among the many questions raised by the Asian economic crisis, I will
focus on a set of issues about the nature of IMF-supported programs that
have been raised by several critics, among them Martin Feldstein in Foreign
Affairs. Before doing so, I will briefly discuss the origins of the
crisis. I will not deal in any detail with the question of whether the
Asian miracle is dead, beyond saying that I believe it is not, and that
within a year or two the countries now in crisis will once again be growing
at rates well above the world average.

Origins of the crisis

The economic crisis in Asia unfolded against the backdrop of several
decades of outstanding economic performance. Annual GDP growth in the ASEAN-5
(Indonesia, Malaysia, the Philippines, Singapore, and Thailand) averaged
close to 8 percent over the lastdecade. Moreover, during the 30 years preceding
the crisis per capita income levels had increased tenfold in Korea, fivefold
in Thailand, and fourfold in Malaysia. Indeed, per capita income levels
in Hong Kong and Singapore now exceed those in some Western industrial
countries. And until the current crisis, Asia attracted almost half of
total capital inflows to developing countriesnearly $100 billion
in 1996.

Nevertheless, there were problems on the horizon. First, signs of overheating
had become increasingly evident in Thailand and other countries in the
region in the form of large external deficits and property and stock market
bubbles. Second, pegged exchange rate regimes had been maintained for too
long, encouraging heavy external borrowing, which led, in turn, to excessive
exposure to foreign exchange risk by domestic financial institutions and
corporations. Third, lax prudential rules and financial oversight had permitted
the quality of banks loan portfolios to deteriorate sharply.

Developments in the advanced economies and global financial markets
contributed significantly to the buildup of the crisis. In particular,
weak growth in Europe and Japan since the beginning of the 1990s had left
a shortage of attractive investment opportunities in those economies and
kept interest rates low. Large private capital flows to emerging markets,
including the so-called carry trade, were driven, to an important degree,
by these phenomena, along with an imprudent search for high yields by international
investors without due regard for the potential risks. Also contributing
to the crisis were the wide swings in the yen/dollar exchange rate over
the previous three years.

In the case of Thailand, the crisis, if not its exact timing, was predicted.
Beginning in early 1996, a confluence of domestic and external shocks revealed
vulnerabilities in the Thai economy that, until then, had been masked by
rapid economic growth and the weakness of the U.S. dollar to which the
Thai baht was pegged. But in the following 18 months leading up to the
floating of the Thai baht in July 1997, neither the IMF in its continuous
dialogue with the Thai authorities, nor increasing market pressure, could
overcome their sense of denial about the severity of their countrys
economic problems. Finally, in the absence of convincing policy action,
and after a desperate defense of the currency by the central bank, the
crisis in Thailand broke.

Should the IMF have gone public with its fears of impending crisis?
While we knew that Thailand was extremely vulnerable, we could not predict
with certainty whether, or when, crisis would actually strike. For the
IMF to arrive on the scene like the fire brigade with lights flashing and
sirens wailing before a crisis occurs, would risk provoking a crisis that
might never have occurred. Short of that, IMF management and staff did
do everything possible to convince Thailand to take timely, forceful action,
but without success.

Once the crisis hit Thailand, the contagion to other economies in the
region appeared relentless. Some of the contagion reflected rational market
behavior. The depreciation of thebaht could be expected to erode the competitiveness
of Thailands trade competitors, and this put downward pressure on
their currencies. Moreover, after their experience in Thailand, markets
began to take a closer look at the problems in Indonesia, Korea, and other
neighboring countries. And what they saw to differing degrees in different
countries were some of the same problems as in Thailand, particularly in
the financial sector. Added to this was the fact that as currencies continued
to slide, the debt service costs of the domestic private sector increased.
Fearful about how far this process might go, domestic residents rushed
to hedge their external liabilities, thereby intensifying exchange rate
pressures. But even if individual market participants behaved rationally,
the degree of currency depreciation that has taken place exceeds by a wide
margin any reasonable estimate of what might have been required to correct
the initial overvaluation of the Thai baht, the Indonesian rupiah, and
the Korean won, among other currencies. To put it bluntly, markets overreacted.

Thailand, Indonesia and Korea face a number of similar problems, including
the loss of market confidence, deep currency depreciation, weak financial
systems, and excessive unhedged foreign borrowing by the domestic private
sector. Moreover, all suffered from a lack of transparency about the ties
between government, business, and banks, which has both contributed to
the crisis and complicated efforts to defuse it. But the countries also
differ in important ways, notably in the initial size of their current
account deficits and the stages of their respective crises when they requested
IMF support.

The design of the programs that the IMF is supporting in Thailand, Indonesia
and Korea reflects these similarities and these differences. 6
These programs have sparked considerable controversy on a range of issues.
First, some have argued that they are merely the same old IMF austerity
medicine, inappropriately dispensed to countries suffering from a different
disease. Second is the criticism that by attempting to do more than restore
macroeconomic balance -- for instance in the measures to restructure the
financial systems and improve corporate governance -- the programs intrude
inappropriately on matters that should be left to the country to handle.
Further, it is argued, that by doing so, the Fund discourages others from
coming to the Fund for financial assistance before they have absolutely
no choice. Yet others criticize the programs for not intervening enough,
for instance for failing to tackle further reforms in such areas as workers
rights and environmental protection. Third, many people are troubled by
questions of moral hazard, especially as regards foreign commercial lenders.

Are the programs too tough?

In weighing this question, it is important to recall that when they
approached the IMF, the reserves of Thailand and Korea were perilously
low, and the Indonesian rupiah was excessively depreciated. Thus, the first
order of business was, and still is, to restore confidence in the currency.
To achieve this, countries have to make it more attractive to hold domestic
currency, which, in turn, requires increasing interest rates temporarily,
even if higher interest costs complicate the situation of weak banks and
corporations. This is a key lesson of the tequila crisis in Latin America
1994-95, as well as from the more recent experience of Brazil, the Czech
Republic, Hong Kong and Russia, all of which have fended off attacks on
their currencies in recent months with a timely and forceful tightening
of interest rates along with other supporting policy measures. Once confidence
is restored, interest rates can return to more normal levels.

Why not operate with lower interest rates and a greater devaluation?
This is a relevant tradeoff, but there can be no question that the degree
of devaluation in the Asian crisis countries is excessive, both from the
viewpoint of the individual countries, and from the viewpoint of the international
system.

Looking first to the individual country, companies with substantial
foreign currency debts, as so many companies in these countries have, stand
to suffer far more from a steep slide in the value of their domestic currency
than from a temporary rise in domestic interest rates. Moreover, when interest
rate action is delayed, confidence continues to erode. Thus, the increase
in interest rates needed to stabilize the situation is likely to be far
larger than if decisive action had been taken at the outset. Indeed, the
reluctance to tighten interest rates forcefully at the beginning has been
an important factor in perpetuating the crisis.

From the viewpoint of the international system, the devaluations in
Asia will lead tolarge current account surpluses in those countries, damaging
the competitive positions of other countries and requiring them to run
current account deficits. Although not by the intention of the authorities
in the crisis countries, these are excessive competitive devaluations,
not good for the system, not good for other countries, indeed a way of
spreading the crisis -- precisely the type of devaluation the IMF has the
obligation to seek to prevent.

On the question of the appropriate degree of fiscal tightening, the
balance is a particularly fine one. At the outset of the crisis, countries
needed to firm their fiscal positions, both to make room in their budgets
for the future costs of financial restructuring, and --depending on the
balance of payments situation -- to reduce the current account deficit.
In calculating the amount of fiscal tightening needed to offset the costs
of financial sector restructuring, the programs include the expected interest
costs of the intervention, not the capital costs. For example, if the cost
of cleaning up the financial sector is expected to amount to 15 percent
of GDP -- a realistic estimate for some countries in the region -- then
the corresponding fiscal adjustment would be about 1.5 percent of GDP.
This is an attempt to spread the costs of the adjustment over time rather
than concentrate them at the time of the crisis. Among the three Asian
crisis programs, the balance of payments factor was important only in Thailand,
which had been running a current account deficit of about 8 percent of
GDP.

The amount of fiscal adjustment in Indonesia was one percent of GDP;
in Korea it was 1.5 percent of GDP; and in Thailand -- reflecting its large
current account deficit -- the initial adjustment was 3 percent of GDP.
After these initial adjustments, if the economic situation in the country
weakened more than expected, as it has in the three Asian crisis countries,
the IMF has generally agreed with the country to let the deficit widen
somewhat, that is, to let automatic stabilizers operate. However, the level
of the fiscal deficit cannot be a matter of indifference, particularly
since a country in crisis typically has only limited access to borrowing
and the alternative of printing money would be potentially disastrous in
these circumstances. Nor does the IMF need to persuade Asian countries
of the virtues of fiscal prudence -- indeed, in two of the crisis countries,
the government has insisted on a tighter fiscal policy than the Fund had
suggested.

Thus on macroeconomics, the answer to the critics is that monetary policy
has to be kept tight to restore confidence in the currency, and that fiscal
policy was tightened appropriately but not excessively at the start of
each program, with automatic stabilizers subsequently being allowed to
do their work. That is as it should be. Moreover, these policies are showing
increasing signs of success in Thailand and Korea, and interest rates could
begin to come down if market confidence and the currencies continue to
strengthen.

Structural policies

Macroeconomic adjustment is not the main element in the programs of
Thailand, Indonesia, and Korea. Rather financial sector restructuring and
other structural reforms lie at the heart of each program -- because the
problems they deal with, weak financial institutions, inadequate bank regulation
and supervision, and the complicated and non-transparent relations among
governments, banks, and corporations, lie at the heart of the economic
crisis in each country.

It would not serve any lasting purpose for the IMF to lend to these
countries unless these problems were addressed. Nor would it be in the
countries interest to leave the structural and governance issues
aside: markets have remained skeptical where reform efforts are perceived
to be incomplete or half-hearted, and market confidence has not returned.
Similarly, the Fund has been accused of encouraging countries to move too
quickly on banking sector restructuring: we have been urged to support
regulatory forbearance, leaving the solution of the banking sector problems
for later. This would only have perpetuated these countries economic
problems, as experience in Japan has shown. The best course is to recapitalize
or close insolvent banks, protect small depositors, require shareholders
to take their losses, and take steps to improve banking regulation and
supervision. Of course, the programs take individual country circumstances
into account in determining how quickly all of this -- including the recapitalization
of banks -- can be accomplished.

Martin Feldstein proposes three questions the IMF should apply in deciding
whether to ask for the inclusion of any particular measure in a program.
First, is it really necessary to restore the countrys access to the
international capital markets? The answer in the case of the Asian programs
is yes. Second, is this a technical matter that does not interfere unnecessarily
with the proper jurisdiction of a sovereign government? The answer here
is complicated, because we have no accepted definitions of what is technical,
or what is improper interference. Banking sector reform is a highly technical
issue, far more than the size of the budget deficit -- a policy criterion
Feldstein is apparently willing to accept as fit for inclusion in a Fund
program. Nor is it clear why trade liberalization -- which has long been
part of IMF and World Bank programs -- is any less an intrusion on a sovereign
government than banking sector reform. Nor does Feldstein explain why the
programs supported by the Fund in the transition economies, including Russia
-- which are far more detailed, far more structural, and in many countries
as controversial as in Asia -- are acceptable, but those in Asia are not.
Third, if these policies were practiced in the major industrial economies
of Europe, would the IMF think it appropriate to ask for similar changes
in those countries if they had a Fund program? The answer here is a straightforward
yes.

Interesting as they are, Feldsteins three criteria omit the most
important question that should be asked. Does this program address the
underlying causes of the crisis? There is neither point nor excuse for
the international community to provide financial assistance to a country
unless that country takes measures to prevent future such crises. That
is the fundamental reason for the inclusion of structural measures in Fund-supported
programs. Ofcourse, many of these measures take a long time to implement,
and many of them are in the purview of the World Bank, which is why the
overall framework for longer-term programs, such as those in Asia, typically
include a series of World Bank loans to deal with structural issues.

Moral hazard

The charge that, by coming to the assistance of countries in crisis,
the IMF creates moral hazard has been heard from all points of the political
compass. The argument has two parts: first, that officials in member countries
may take excessive risks because they know the IMF will be there to bail
them out if they get into serious trouble; and second, that because the
IMF will come to the rescue, investors do not appraise -- indeed do not
even bother to appraise -- risks accurately, and are too willing to lend
to countries with weak economies.

It would be far-fetched to think that policymakers embarking on a risky
course of action do so because the IMF safety net will save them if things
go badly. All the evidence is many countries do their best to avoid going
to the Fund. Nor have individual policymakers whose countries end in trouble
generally survived politically. In this regard, Fund conditionality provides
the right incentives for policymakers to do the right thing -- indeed,
these incentives have been evident in the preemptive actions taken by some
countries during the present crisis. These incentives may even be too strong,
and I agree with Martin Feldstein that it would generally be better if
countries were willing to come to the Fund sooner rather than later. But
I do not believe countries should have too easy access to the Fund: the
Fund should not be the lender of first resort; that is the role of the
private markets.

The thornier issues arise on the side of investors. Economists tend
to point to the problems of moral hazard and the inappropriate appraisal
of risks; others are more concerned that some investors who should have
paid a penalty -- and typically they refer to the banks --may be bailed
out by Fund lending. These are two sides of the same coin: if investors
are bailed our inappropriately, then they will be less careful than they
should be in future.

First the facts. Most investors in the Asian crisis countries have taken
very heavy losses. This applies to equity investors, and to many of those
who have lent to corporations and banks. With stock markets and exchange
rates plunging, foreign equity investors had by the end of 1997 lost nearly
three quarters of the value of their equity holdings in some Asian markets
-- though to be sure, those with the courage to hold on, have done better
since the turn of the year. Many firms and financial institutions in these
countries will unfortunately go bankrupt, and their foreign and domestic
lenders will share in the losses.

Some short-term creditors, notably those lending in the inter-bank market,
were protected for a while, in that policies aimed to ensure that these
credits would continue to be rolled over. In the case of Korea, where bank
exposure is largest, the creditor banks have now been bailed in,
with the operation to roll over and lengthen their loans having been successfully
completed earlier this week. Further, we should not exaggerate the extent
to which banks have avoided damage in the Asian crisis: fourth-quarter
earnings reports indicate that, overall, the Asian crisis has been costly
for foreign commercial banks.

None of this is to deny the problem of moral hazard. It exists, and
it has always to be borne in mind, and we need to find better ways of dealing
with it. But surely investors will not conclude from this crisis that they
need not worry about the risks of their lending because the IMF will come
to their rescue. Investors have been hit hard. They should have been, for
they lent unwisely. But there remains the question: if it was not mainly
moral hazard that led to the unwise lending that underlies the Asian crisis,
what was it? The answer is irrational exuberance.

Financial crises based on swings in investor confidence -- on irrational
exuberance, and also on irrational depression, not really irrational in
lacking some foundation in fact, but sometimes representing an excessive
reaction -- far predate the creation of the IMF, and would not be avoided
even if the IMF did not exist. This is not something to applaud. Rather
we have to do everything we can to provide the information and incentives
that will encourage rational investor behavior. We do need, as I
will discuss shortly, to find better ways to bail in the private sector
more systematically. But we cannot build a system on the assumption that
crises will not happen. There will be times at which countries are
faced by a massive reversal of capital flows and potentially devastating
loss of investor confidence. Thus we need in the system the capacity to
respond to crises that would otherwise force countries to take measures
unduly "destructive of national or international prosperity".

The IMF is part of that system of response, to help countries when markets
overreact. Here I would like briefly to discuss the role of IMF lending
-- and I emphasize that the IMF lends money, and gets repaid, it
does not give it away -- and the issue of bailouts on a more fundamental
level.

When the IMF lends in a crisis, it helps moderate the recession that
the country inevitably faces. That means that the residents of that country,
its corporations, and some of the lenders to that country, do better than
they otherwise would have. That is not in any meaningful sense a bailout,
provided lending of this type can be sustained in future crises. Rather,
if properly designed to avoid as far as possible creating the wrong incentives
for the private sector, it represents rational lending -- not grants or
handouts -- in conditions when markets appear to have overreacted.

To ensure that lending of this type can be sustained in future crises,
we have to be surethat the required size of Fund loans does not keep rising,
which means that in seeking to improve the architecture of the international
system, we will have to find ways of discouraging unwise private lending
-- that is to help ensure that risk is properly priced, and to limit the
required scale of official lending, in part by finding ways of sharing
the burden between the official and private sectors.

The alternative proposed by those who would abolish the IMF is to leave
countries and their creditors to sort out the countrys inability
to service its debts. That sounds simple, but it has rarely been so in
practice. That is one reason that the IMF assisted the Asian crisis countries
to avoid defaults or debt moratoria. In the absence of an accepted bankruptcy
procedure for dealing with such cases, given that the debts involved generally
involve both sovereign and private obligations, and given the free rider
problem, the experience -- from the inter-War period and the 1980s -- is
that workouts have been protracted, and that countries have been denied
market access for a long time, at a significant cost to growth. By contrast,
in the Mexican crisis of 1994-95, market access was lost for only a few
months, and Mexico returned within a year to impressive growth assisted
by its ability to tap the international capital markets. Similarly, in
the present Asian crisis, it is quite likely that both Korea and Thailand
will be back to the international markets within a few months. That surely
bodes well for their recoveries, which it is reasonable to expect will
begin later this year.

The second reason that the IMF tried to help countries avoid a standstill
was the fear of contagion. We believed, and continue to believe, that a
standstill by one country, at a time when markets were highly sensitive,
would have spread to other countries and possibly other continents. That
nearly happened in October, but due to prompt and courageous action by
Brazil, did not.

Of course, we cannot know what would have happened had there been no
official lending in the Asian crisis. But we do know that the crisis has
been contained, and it is reasonable to believe that, deep and unfortunate
as the crises in individual countries have been, growth in those economies
can resume soon.

Architecture of the international financial system

After every crisis, the international community reflects on what needs
to be done to reduce the probability of future crises, and to ensure that
crises that do occur can be handled more effectively. After the Mexican
crisis the emphasis was on better provision of information to the market.
Now the focus is on the architecture of the international system, specifically
crisis prevention through the arrangements for monitoring and regulating
flows of international capital, and crisis response to improve the
systems response when a crisis occurs.

Let me make five points on crisis prevention. First, there is a need
to increase the flowof timely, accurate, and comprehensive data to the
public. Through the Special Data Dissemination Standard, the IMF is encouraging
countries to move toward greater transparency and fuller disclosure; and
it will be necessary to strengthen the standard, for instance by providing
data on forward transactions by central banks. Better data provision should
lead not only to better informed investor decisions, but also to better
policies by governments, for some of the off-balance sheet activities of
central banks that were instrumental in the recent crisis could not have
continued for as long as they did had they been public knowledge. It is
also clear from the present crisis that we need better and more timely
data on short term debt exposures, not only of banks, but also of corporations.
The Bank for International Settlements is already working hard to improve
the short-term debt data. At the same time as we work to improve the coverage,
quality and timeliness of data, we need to recognize that data do not provide
information until they are processed by human intelligence -- which means
we need to improve our ability to read the meaning of the data, through
research into crisis indicators, and through official and private sector
surveillance of the international system.

Thus, second, ways need to be found to enhance the effectiveness of
Fund surveillance --by ensuring, among other things, that all the relevant
data is being supplied to the Fund, that countries exchange rate
regimes are consistent with other policies, and that capital inflows are
sustainable. The question, already discussed, of whether the Fund should
provide more public information, and if necessary issue public warnings,
is sure to be agenda. Many have argued that the efficient functioning of
the international system requires greater transparency at the IMF itself.
This is happening, and the trend should continue.

The international system also needs to monitor international capital
flows far more actively, to seek to identify potential trouble spots. The
provision of better data on short-term debt flows and exposures will be
critical to this effort. Henry Kaufman, who has written convincingly on
the need for such monitoring, has suggested we consider setting up a separate
international institution for this purpose, but we are not short of international
institutions and do not need another one to do this.

Third, since crises are often provoked by problems in the financial
sector or intensified by them, much more needs to be done to strengthen
domestic financial systems. The IMF has been working in this direction
by helping to develop and disseminate a set of best practices in the banking
area, so that standards and practices that have worked well in some countries
can be adapted and applied in others. These standards are codified in the
Basle Committee on Banking Supervisions 25 core principles, introduced
last year. This standard-setting effort is extremely important. But the
international system also needs to develop mechanisms to monitor the implementation
of the standards, to help ensure that countries meet the standards to which
they have subscribed. IMF surveillance will play an important role in this
regard.

Fourth, we need to improve the way capital markets operate, in both
advanced andemerging market countries. One possibility would be to encourage
countries to adopt international standards in areas needed for the smooth
operation of financial markets, such as bankruptcy codes, securities trading,
and corporate governance, including accounting. Market participants would
then have clearer basis for making their lending decisions. Once again
the international system would need to find a way of monitoring the implementation
of these standards, and this is a formidable task. Observance of these
standards would be encouraged if the risk weightings on international loans
applied by bank regulators in the lending countries reflected compliance
of the borrowing countries with the standards.

Fifth, the opening of countries capital accounts should be handled
prudently. This means neither a return to pervasive capital controls, nor
a rush to full immediate liberalization, regardless of the risks: the need
is for properly sequenced and careful liberalization, so that a larger
number of countries can benefit from access to the international capital
markets. In particular, macroeconomic balance and a strong and well-supervised
financial system, are prerequisites for successful liberalization. To facilitate
this process -- to encourage the orderly liberalization of the capital
account -- the IMF is at work on an amendment of its charter that will
make the liberalization of capital movements a purpose of the Fund.

Some steps have been taken in the direction of crisis response. Through
the creation of the Emergency Financing Mechanisms, the IMFs internal
procedures for dealing with crisis situations have been streamlined, an
initiative that allowed the program for Korea to be negotiated, signed,
and approved in less than two weeks. The IMF has also tailored the new
Supplemental Reserve Facility to fit the special circumstances of financial
crises in emerging markets.

Considerable thought is also being given to finding a mechanism for
involving the private sector in the resolution of financial crises in a
timely way -- the bail-in question, an issue that was intensively discussed
after the Mexican crisis, and to which there is no easy solution. There
have been many suggestions, among them that we need the equivalent of an
international bankruptcy court or code, and that the international system
needs to find a way to authorize a temporary stay on payments in an external
financial crisis. There are formidable legal problems in this area, but
the search for ways to deal with this problem must continue. Whatever solutions
may be suggested, it will be important to bear in mind the dangers of contagion,
the possibility that an effort to involve the private sector in solving
the problems of one country will lead to capital outflows from others,
thus spreading the crisis even as it may be contained in the originating
country.

Finally, it should be apparent that the IMF cannot perform a central
role in crisis prevention and crisis management without adequate resources,
including in particular, the increase in IMF quotas now being considered
by the Congress.

The new architecture of the international financial system is still
on the drawing board, and it remains to be seen how the international community
will decide to deal with these issues, and what precisely the role of the
IMF will be. But even if the IMF has its shortcomings -- and like all of
us, it does -- it provides a flexible framework for the international community
to address global economic and financial problems that exceed the capacity
of individual countries to resolve alone, and for sharing fairly the burden
of managing the international system. That has been the source of the strength
of the IMF, an institution established more than half a century ago to
help restore an international economic system ravaged by depression and
war.

Under the steadfast leadership of the United States during this long
period, that goal has been achieved, and we again have a truly global international
system. Its benefits in improved living standards in the United States
and around the world far outweigh the costs that have been evident in recent
crises. But we can do better yet, and for that purpose United States leadership
remains indispensable.

Thank you.

1 Stanley Fischer is First Deputy Managing Director
of the International Monetary Fund. He is grateful to Mary Elizabeth Hansen
for assistance. This paper was prepared for delivery as the Forum Funds
Lecture at UCLA on March 20 1998.

2 The Executive Board has 24 members, called Executive
Directors, appointed by and representing the 182 member countries. Eight
Executive Directors, those for the largest countries, represent only their
own countries; the 16 other chairs are organized into constituencies, each
representing several countries. Each countrys vote is proportional
to its share in the Fund, with the United States currently holding about
18 percent of the shares. A majority of 85 percent is required for most
major decisions.

3 Information about Fund activities and publications
is available on the Funds website (www.imf.org).

4 Because of the lag, fast-growing countries tend to
have relatively low quotas, one of the reasons that the November 1997 loan
to Korea was so big relative to the countrys quota.

5 Among the countries that joined the NAB when it was
set up in the wake of the Mexican crisis were Korea and Thailand. They
are not now in a position to lend to the Fund.

6 The full texts of the most recent letters of intent
outlining their program objectives and commitments are publicly available
via the IMFs web-site: (www.imf.org)